Problems in the Fund Business

The mutual fund industry is in a bit of a pickle these days. The outflow of assets from domestic stock funds has turned into a cascade this year, with such funds losing more than $50 billion in net outflows so far in 2012. As ETFs and hedge funds have grown in popularity — and much of the middle class has lost the kind of savings that traditionally went into mutual funds — good old-fashioned equity funds have fallen by the wayside.

On top of that, there have been several studies and investigations recently challenging the efficacy and usefulness of mutual funds as an investment. The mutual fund business is in the process of getting kicked when it’s down. Here are four examples. 

1. The most widely publicized of these was a study out of Indiana University charging that fund managers — especially inexperienced ones — are too likely to invest in companies from their home states. Compared to their peers, fund managers overweight their investments in their home state by an average of 12 percent. And the managers who were invested the most in their home states ended up with the most inefficient portfolios. While the hometown investments didn’t necessarily underperform, the overweighting can lead to a portfolio that is poorly diversified, and too susceptible to economic problems affecting a single geographic area.

   All told, the study estimates that there’s around $31 billion worth of mutual fund assets wrongly invested in home-state stocks. The effect is most pronounced in newly installed or inexperienced fund managers, who may not have the knowledge to look outside their home areas for investments. The investments most affected, not surprisingly, are small-cap stocks. So a red flag for any fund would be a manager without a lot of experience who seems to be overinvested in nearby small companies. 

2. Vanguard, one of the biggest mutual fund firms in the nation, recently did a study of its own looking at how high fees affect fund returns over the long haul. The firm’s head of investment counseling and research, John Ameriks, set up some model portfolios for a retiree, age 60, with $100,000 to invest and planning to withdraw just 4 percent of the principal each year. Ameriks assumed a 5 percent annual return, then examined the effect of annual costs of 0.25 percent, 1 percent and 2 percent.

   Those costs are small enough that many investors might just pass over them without notice — even 2 percent a year doesn’t sound like that much. But just a 1 percent fee structure means the investor is costing herself the equivalent of 25 percent of her withdrawals every year. By the time the retiree turns 65, the high-expense portfolio cuts into the withdrawals by 8.3 percent over the low-expense one. In 15 years, the gap is up to 20 percent.

   The low-expense portfolio allows the retiree to withdraw that 4 percent every year without eroding the principal, while the higher-expense portfolios are losing principal every year. If the person is fortunate enough to live to age 90, the difference in portfolios comes to $45,000. Ameriks describes the study in detail at the Vanguard Web site here. 

3. The personal-finance magazine SmartMoney — which, coincidentally, ceased print publication right after reporting this story — looked at a similar issue, the exorbitant fees that are often paid to mutual fund director. SmartMoney found that directors are typically asked to attend roughly four to eight board meetings a year, and as a result, are paid an average of about $260,000 per year. And many of these directors serve on more than one board. One fund director gets more than $1 million every year while overseeing 170 funds, or pretending to do so.

   That’s a big reason expense ratios tend to be so high for actively managed funds. Actively managed stock funds charge an average of 0.9 percent in fees, as opposed to 0.16 percent for index funds. According to Morningstar, only 23 percent of actively managed stock funds beat their benchmark last year, and only 20 percent beat the S&P 500.

4. Finally, two Stanford business school professors, Jonathan Berk and Jules Van Binsbergen, recently published a paper showing that there are discrepancies between respected and widely used sources of mutual fund returns. By checking Morningstar returns against the industry-standard database CSRP, the two researchers found that 3.3 percent of the returns were different.

   Many of the reported errors are trivial, but some of them are not. According to Berk and Van Binsbergen, 1.3 percent of the Morningstar data misreported actual returns by more than 10 basis points.

   On the other hand, that same paper reported some good news for mutual funds, especially actively managed ones. By comparing fund returns to their benchmarks, the authors found that the average fund manager adds value of $140,000 per month, and that their skills were both statistically significant and repeatable. That puts the value of a good fund manager at more than $2 million a year. With all else that has befallen the beleaguered mutual fund industry, that’s a statistic they may want to start trumpeting.

For more from Tom Nawrocki, see:

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